Presentation Description

A floating rate note has variable coupons, depending on a money market reference rate, such as LIBOR, plus a floating spread. When interest rate raises, the coupons of a FRN increases in line with the increase of the forward rates, which means its price remains relatively constant. Therefore, FRNs bear small interest rate risk. On the other hand, FRNs carry lower yields than fixed rate bonds of the same maturity. They also have unpredictable coupon payments.
The price of a FRN has very low sensitivity to changes in interest rates because the floating coupon increases but the discounting also increases as interest rate rises. An investor who wants conservative investments may choose floating rate bonds. FRNs become more popular when interest rates are expected to increase. A FRN carry lower yield than fixed rate bonds of the same maturity and has unpredictable coupon payments. This presentation gives an overview of FRNs valuation. You can more information at http://www.finpricing.com/lib/FiFrn.html

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Floating Rate Note
Floating Rate Note Introduction
 A floating rate note FRN also called floating rate bond is a bond
in which the investor will receive coupons paid by the issuer at a
floating coupon equivalent to a money market reference rate such
as LIBOR or federal fund rate plus a spread at specified dates before
bond maturity.
 The bond principal will be returned at maturity date.
 Almost all FRNs have quarterly coupons.
 FRNs are usually issued by corporations federal agencies
municipalities and states/provinces to finance a variety of projects
and activities.

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Floating Rate Note
The Use of Floating Rate Notes
 A FRN carry little interest rate risk as its duration is close to zero due
to periodic reset.
 The price of a FRN has very low sensitivity to changes in interest
rates because the floating coupon increases but the discounting
also increases as interest rate rises.
 An investor who wants conservative investments may choose
floating rate bonds.
 FRNs become more popular when interest rates are expected to
increase.
 A FRN carry lower yield than fixed rate bonds of the same maturity.
 FRNs have unpredictable coupon payments.

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Floating Rate Note
Practical Guide
 The present value of a bond computed by any pricing models is the
dirty price of the bond. To purchase a bond the buyer pays this
dirty price.
 Although investors pay dirty prices bonds are typically quoted in
terms of clean prices.
Dirty Price Clean Price + Accrued Interest
 Intuitively −+ can be regarded as a credit risk adjusted
discount factor.
 To use the model one should first calibrate the model price to the
market quoted price by solving the credit spread. Comparing to
curve construction or calibration for exotic products the solving
here is very simple.

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Floating Rate Note
Practical Guide Cont
 After making the model price equal to the market price one can
calculate sensitivities by shocking interest rate curve and credit
spread.
 We use LIBOR curve plus credit spread rather than bond specific
curves for discounting because bond specific curves rarely exist in
the market especially issued by small entities. Using LIBOR curve
plus credit spread not only accounts for credit/issuer risk but also
solves the missing data issue.
 Usually the forecasting curve is different from the discounting
curve. For instance the forecasting curve is the treasury curve but
the discounting curve is the LIBOR curve plus credit spread.